Canadian pension funds were built to last and appear to be surviving the credit crisis. Elizabeth Pfeuti reports from Toronto on this and how increasing commitment to global assets and SRI will affect funds
Once seen by the rest of the world as an extension of the US, in recent times Canada has emerged as an institutional investment hotspot in its own right. A strong domestic equity market and a currency which refused to be pulled down by its neighbouring namesake has created an environment which was able to weather the storm of the past 12 months better than most. A home bias to equity investments, common to most pension funds across the globe, has done Canadian investors no harm over the past decade.
The Toronto Stock Exchange (TSX) has steadily risen over the past five years from a lowly 6,835 points at the end of May 2003 to an all time high of 15,090 on 20 May this year. Of course there have been brief dips in performance over this time, but the TSX has remained on an upward path despite the blips.
Rob Baillie, CEO at Northern Trust Canada, based in Toronto, said: "Canada has remained relatively unscathed. The main reason is that we never had a sub-prime mortgage industry. That is not to say that the global credit situation has not impacted us, but to a much lesser degree than in the US."
Baillie added: "The crisis meant investors had to spend a great deal of time trying to determine their actual exposure. It's not always very clear because the exposure can be through very complicated securities. Once this was clear, they could assess and put in place risk strategies."
In 2005, the federal government removed the 30% limit on pension funds' foreign holdings, but so far there has not been the expected flood of assets out of the country, for this major reason. Paul Forestell, worldwide partner, Mercer, explained: "Canadian markets are made up of around 75% financial, energy and material companies, which have continued to do well."
Forestell continued: "Those pension funds which had moved away from domestic equity markets and not hedged the currency risk on their investments would have suffered badly over the past year." Baillie pointed out it also made sense for Canadian investors to stick with their own market whilst it produced decent returns, as its liabilities were measured in the home currency.
The Canadian dollar has been a blessing and curse for institutional investors in recent times. For those keeping their money within the country, the strategy has worked well as the currency continued to rise against the US dollar, having gained 60% on it over five years. The 'Loonie' also made gains on the Euro in 2007, but this has largely flattened out since the start of the year.
For this reason, currency hedging has gained a following from pension funds which either saw the incoming danger early and took precautions to mitigate the risk from their global investments or were hurt by their well-performing currency and did not want to get burnt again. Greg Chrispin, managing director, State Street Global Advisors (SSgA), based in Montreal, said investors had been taking more of an interest in currency hedging as a risk management tool as Canada's natural resources, such as oil, continued to buoy the dollar.
Chrispin added: "Some of the more sophisticated plans have shown a renewed interest in active currency management. Most funds invested in global markets are aware of the risk [and] have usually had a hedge in place, but some are now building internal teams to address the value to be found in currency as a separate asset class."
Jim Brace, vice president and institutional investment specialist, Franklin Templeton Investments Corp, expected the Canadian dollar to appreciate slightly over 2008, but said it would be tied to the export demand picture for Canadian commodities, primarily oil and gas. Brace said: "Demand has been strong to date over 2008, but we could see a pull back from these recent highs.
"Currency hedging was only an issue in 2007 for those who weren't there, because of the magnitude of the move in the Canadian dollar. Going forward, there's much less opportunity now," he added. However, Kevin LeBlanc, vice chair, TD Asset Management, said the number of currency mandates awarded had grown as pension plans managed the currency risk associated with increased offshore investments.
This risk has been exacerbated by increased market volatility brought on by central bank intervention and uncertain economic growth globally. LeBlanc admitted some pension funds had joined currency hedging at the later stages, for example at the 0.95 level, but claimed they had still benefited. This recognition of currency hedging may have come at the right time, as pension funds begin to increasingly access global markets.
Funds have begun to up their foreign equities as other manager issues prompted review, according to LeBlanc. He said a shift to global holdings had not happened immediately after the cap was lifted, as investors were waiting for a catalyst or didn't have the momentum to make a change.
But over the past 12 to 18 months, the review of domestic mandates in some cases resulted in a reallocation to global mandates and away from Canada. Chrispin at SSgA said pension funds were looking to products other than plain equities and bonds to get exposure to the international stage.
Bruce Curwood, director, investment strategy, Russell Canada, agreed: "Several years ago the typical Canadian pension fund was 60/40 in equities and bonds, with about half the equities invested in the US and EAFE. "After the foreign property limit was removed, some decided to use a global mandate for the additional foreign equity allocations.
This meant the manager would determine the region and country weights based on market views, not static weights in the US and EAFE." Curwood continued: "However, it's not just equities that are drawing pension funds' interest in the global sphere; alternatives such as hedge funds, private equity, infrastructure and real estate have also become popular."
He said some pension funds would initiate investments into this space on a domestic level, then once comfortable, look globally, reducing their domestic bond or equity allocation based on their objective. Many others made the jump to global alternatives, like hedge funds and infrastructure, immediately, due to limited Canadian product offerings or the need for greater diversity.
Although the cap has been lifted, some larger pension funds had already exceeded that limit by using derivatives. Andrew Kitchen managing director in the global institutional group, SEI, Toronto, said some larger funds had already exceeded the 30% using synthetics, as they felt traditional asset classes had not dealt enough risk away.
Kitchen said: "The move towards more global investing is less about geography and more about exposure to alternatives and asset classes which would de-link portfolios from market gyrations in a liability-linked environment." Some of the bigger funds, such as La Caisse de dépôt et placement de Québec (La Caisse) and Ontario Teachers' Pension Plan (OTPP) have been involved in international investment for some time.
With combined assets under management of C$263bn, if these two, along with the other major public funds, kept a complete 70% of their assets in Canada, they could practically control domestic markets with the amount of capital deployed. Bob Bertram, vice president, investments, OTPP, commented: "We have moved a significant part of our portfolio outside of Canada, but this was not due to the restrictions being lifted.
"The Canadian economy has a very slow growth rate compared to some in the emerging markets. As a long term investor, it's better for us to seek out the economies with better domestic growth," Bertram added.
He said OTPP found China and India too expensive, which went some way to explain their dominance in infrastructure investments in Central and South America. In August 2007, the fund took majority shareholder positions in two Chilean water and waste water companies. La Caisse emphasised the need to have local contact when investing abroad.
OTPP said it had dedicated team members who made regular visits to the companies in which it held direct investments. La Caisse has established offices in India and China to take advantage of the real estate potential in those countries. For smaller funds with fewer investment staff, however, this would clearly not be an option, so do Canadian asset managers have the expertise to offer international products?
Marc Cevey, CEO, HSBC Investments in Toronto, said some current providers may struggle to cover the spectrum of investment options on offer outside the home nation.
Cevey said: "For a long time, Canadian firms have not needed to look outside their own borders. Now they face the challenge of coming up with investment solutions using products outside their traditional offering."
Toronto's Central Business District is dominated by skyscrapers emblazoned with Bank of Montreal, Royal Bank of Canada and TD Asset Management branding; although main players in Canada, these firms are not globally well known or present in other regions. Many of the large global asset managers have also so far been reluctant to take the plunge north of the US border, preferring to run institutional money through nearby New York, Boston or Chicago offices.
LeBlanc at TD said with this growing exposure to global investment, it would be the mid-sized investment firms which would be the most vulnerable. He said: "Either niche managers which have a close focus on these new areas or large firms with extensive products and lines either already available or with the capacity to set them up should do well in this new environment.
"Medium sized players will find themselves stuck in the middle, facing higher research, compliance and risk management costs, without the scale to pay for them," LeBlanc added. Of course investment will still continue to thrive within Canada's borders, but the clever money has already begun pulling away from pure equity exposures, realising the party cannot go on forever.
Following the credit crunch, there has been a 'flight to quality' in the fixed income arena, but a global shortage of government bonds has left pension funds looking elsewhere for inflation hedging investments.
Richard Guay, CIO, La Caisse, said: "Some three to five years ago we made a huge change in the asset mix and moved into what we would call alternatives; hedge funds, private equity, real estate and commodities.
"At the end of 2004 we had 24% in this area, now we have 35%. We are among the pension plans which have the highest weights in other assets in Canada," Guay added. La Caisse aims to continue in the same direction, but probably not at the same speed and not exceeding 40% in this class to avoid liquidity issues, according to the CIO.
Globally, the definition of the alternative label changes from pension fund to pension fund, trustee to trustee, and this trend has continued in Canada.
Chrispin at SSgA said a fund's mindset varied depending on the size and sophistication. He continued: "Some large funds now have direct exposures to private equity and infrastructure in levels we have not previously seen, but this is only a small portion. "Some smaller funds have looked at these asset classes from a risk management point of view and tried to better understand the benefit of investing here in governance terms," Chrispin concluded.
Murray McLean, head of institutional investments, HSBC, Toronto, said major players were quite comfortable with the idea of alternative asset classes, but smaller funds still needed education in the field.
McLean said: "Pension plans know alternatives are good diversifiers, but not all of them understand some of the more complicated structures such as 130/30 or global macro, so need pooled funds to access them." He predicted the smaller funds would gravitate to the more complex instruments in time, but said the trustee board structure, with member turnover and infrequent meetings, made a quick transition to this space difficult.
Peter Muldowney, worldwide partner, Mercer, said real estate had been a staple in Canadian pension fund investing for some time and those with an allocation to it did not consider it 'alternative'. The size of Canada and its relatively small population and tax revenues have made infrastructure an interesting prospect for pension funds looking to deploy capital in their own backyard.
Janet Rabovsky, practice leader at Watson Wyatt based in Toronto, said the lack of a real return bond market in Canada had led pension funds to invest in infrastructure.
Pension funds have entered into partnerships to fund new municipal buildings and transportation networks to cater for the population growth, while replacing worn out structures.
Rabovsky added: "Pension funds are taking money out of equities and putting it into real estate or infrastructure which produce the same return, but without the level of volatility." Hedge funds have attracted the larger plans' direct investment, but, as has been prevalent in other markets, fund of hedge funds have taken the bulk of money offered up to the space by smaller schemes.
Kitchen at SEI said pension funds were also looking into more synthetic alternative products: "Infrastructure and hedge funds are considered alternative for the majority of investors, but they are mainly the larger funds' domain. "Managed futures products and non-traditional bond exposures have provided a grey area between traditional and non-traditional assets, as there is no defined line of what actually is 'alternative'," Kitchen concluded.
Commodities have not had a great following in Canada, as the national stock market has traditionally weighted to that sector. Paintings hung in the old stock exchange, built in 1937 and now used as a museum, illustrated the main composition of the TSX: oil, transportation, communication, mining and industrial agriculture.
These themes have continued to the present day, so managers pushing commodity products may not find a willing audience in Canada. LeBlanc at TD said mandates were increasingly being awarded in the alternatives space, which may signal the end of an education process and a reluctance to act differently than their peers.
Brace at Franklin Templeton said the challenge had fallen to asset managers to come up with alternative asset class packages for small and medium sized pension funds which were both cost effective and met the needs of the marketplace.
Despite being one of the first countries to acknowledge socially responsible investing (SRI), Canadian pension funds seem not to have continued this charge with their asset allocation. Only four pension funds and none of the major national asset managers have signed up to the UN PRI.
Canadian church groups initially researched corporate responsibility in the 1970s and Mercer has based its SRI team in Toronto, so the country is clearly aware of the issues; but why have SRI concerns fallen down trustee board priorities?
Greg Chrispin, managing director, State Street Global Advisors (SSgA), based in Montreal, said: "SRI is an emerging trend and it very much depends on the sector [as] to how the fund reacts to these issues."
"Some public funds have objective setting in this sphere and on the west coast they are further advanced in terms of research. Endowments have been keener on SRI, as they have pressure from students."
Canadian pension funds on the whole have not responded well to a negative screening process. Marc Cevey, CEO, HSBC Investments in Toronto, explained: "SRI has been seen as detrimental to some, as through negative screening they may lose good returns. "There has been a gradual shift towards positive screening, which would no longer exclude an entire sector but see investors selecting the best in breed in terms of corporate responsibility and doing well as a result," Cevey continued.
He added that asset managers had started to incorporate SRI principles into mainstream fund specifications, not creating separate vehicles to cater to the theme.
Bruce Curwood, director, investment strategy, Russell Canada, agreed: "Pension funds are aware of what's going on and have been looking into SRI, but many think it is restrictive.
"The hardest part is getting consensus between stakeholders as to what to avoid, but still ensure good enough returns. Whose definition of ethical investments or SRI do you use?" Curwood added.
Richard Guay, CIO, La Caisse de dépôt et placement de Québec, one of the four funds in the UN initiative, said it had its own SRI policy: "We get involved with proxy voting and engage with a company if we feel there are issues to be addressed."
Guay continued: "Divestment is the last resort. We prefer to monitor whether a company is working towards better governance as just pulling money out has no impact on the business and could hurt our portfolio." Bob Bertram, vice president, investment, Ontario Teachers' Pension Plan, said SRI screening could become a box ticking exercise.
Bertram continued: "Any constraint costs money and we don't think it has been effective. "We prefer to look at risk factors which include some SRI aspects, otherwise people can pick and choose what they screen for."
Defined contribution (DC) is not a new phenomenon in Canada, nor are company pension plans converting as quickly as elsewhere in the world, but the strategy faces the same hurdles. Some 15 years ago, when markets were doing well, DC seemed to offer better retirement income potential and with less risk on the sponsoring company, it took off in a big way, but the journey since that time has not been smooth.
Scott Perkin, president, Association of Canadian Pension Management (ACPM), said: "We have just released a paper on DC discussing what changes might be considered.
"There are not a lot of rules around DC schemes and although they are caught by provincial law, a lot of it is really written for DB plans," Perkin added.
Monique Tremblay, senior vice president, Desjardins Financial Security, said the biggest problem in the DC space was poor member awareness about how to make the best of their contributions and poor understanding of investment options. Tremblay continued: "We need simplification and a more uniform legislative environment for employers.
"We already have tools and instruments available for members and sponsor companies, but they have to learn what they are and how to use them." Hybrid schemes have been around for a while, but they remain the exception, not the rule. US DC members bringing class action suits over badly managed funds have resonated with ACPM.
Perkin concluded: "We're trying to find how plan sponsors and governments can make changes now so DC plans are robust and members know what their responsibility is regarding returns. "That's the goal of the plan."
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